Caught short by weak world

China cannot protect us from the bleakness of the world economy in quite the way it once could.

Its investment- and export -driven growth model clearly was in need of more accelerated reform before the global economic crisis. The global crisis and the slow recovery have made the transition to the next phase of China’s emergence more urgent and more difficult.

It is more urgent because the dawdling recovery in the United States (growth slowed to an annual rate of just 1.3 per cent in the June quarter) and the recession in Europe mean China’s two major export markets cannot support the growth that China needs.

It is more difficult because the transition to a household demand-driven economy, with its need for a rapidly expanded service sector, will be occurring as the banks and regional governments are under pressure because of problems in the export sector and debts incurred defending the economy in the global crisis.

So, in its latest World Economic Outlook report, the International Monetary Fund asks the two questions about the global economy of most immediate interest to Australians. Can the US and Europe do better? And how will Australia’s biggest export market, and the commodities we sell, be affected?

The IMF’s answer to the first question always is yes. The US and Europe certainly can do better. And it’s a fair bet the US will – after the November election is out of the way. Europe is not such a sure thing.

Both economies have large public debt as a result of the financial crisis, and these must be stabilised as a share of gross domestic product. That will require fiscal consolidation which, if applied ineptly, could hobble their economic recoveries.

A stock IMF prescription has been to nurture growth now but have a credible consolidation plan for the medium term.

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In the case of the US, nurturing growth now starts with not falling over the so-called fiscal cliff – the radical fiscal tightening that has been legislated for next year – which would push the US into recession.

It also requires support from monetary policy, which the US Federal Reserve is trying to provide through its quantitative easing, or QE3, program.

The success of the Fed’s QE3 remains to be seen. If it fails, the next step may have to be a much more controversial use of the Fed’s printing presses to boost spending.

But, for America’s politicians, the medium-term fiscal challenge may be even scarier. That, the IMF stresses, will need to be based on structural fiscal reforms: permanent cuts to entitlements and tax reform.

The US government, it says, will simply have to raise more revenue. The IMF recommends a value-added or, as we would call it, a goods and services tax.

Because the Americans have a history of successful economic management, we can reasonably expect their politicians to rise to the occasion. We just have to hope they won’t take too long.

Europe, though, seems a more difficult challenge, not because the euro zone’s public debt is so large – it is about the same size as that of the US – but because the sovereign debt problems have turned the euro area into something that none of its member states agreed to join.

No one in Germany or the other prosperous northern states went into the euro expecting to have to take on the debts of the south. And no one in the south agreed to federal control from Germany. But that almost certainly is what will have to happen if the euro is to survive. Again, the rest of the world can only hope the Europeans quickly resign themselves to reality.

We have multiple links with the economic problems in Europe and the US, but one of the most important, obviously, is via China and Asia.

We depend on Asia to buy our minerals and Asia depends on the consumers of Europe and the US to buy its manufactured goods.

Weakness in Europe and the US translates into slower growth in China and the emerging economies as a whole, which translates into lower prices for commodities.

The new analysis by the IMF shows that each 1 per cent decline in China’s fixed asset investment leads to a drop of 0.8 per cent in the price of iron ore within one year, while the aluminium price falls by about 1 per cent, copper’s by about 1.6 per cent, and lead, nickel and zinc prices by about 2 per cent.

Among the worst-affected emerging market economies in China's regional supply chain will be Taiwan, which loses almost 1 percentage point of growth for a 1 per cent fall in Chinese investment, and South Korea and Malaysia, which both lose 0.5 of a percentage point.

South Korea is another major export market for Australia.

So here we sit at the end of the supply chain, unable to do much except get our own house in order. The less we can rely on global commodity markets to generate increases in our living standards, the more we have to revive productivity growth.

Like China, we will need to accelerate difficult reform that would have been much less painful had we started earlier.